Just before Christmas, news reports surfaced that President Trump was discussing how to go about firing Jerome Powell, Chairman of the Federal Reserve, ten months after having him appointed to the post. The purported reason: Mr. Trump was blaming stock market turbulence–not on his tax bill, which failed to reform the system and increased the government deficit, nor on the negative effect of his tariffs–but on Mr. Powell’s continuing to gradually raise short-term interest rates from their financial crisis lows back toward normal.

Ironically, the S&P 500 plunged by about 10%, making what I think will be seen as an important low, as the president’s deliberations became public.

why this is scary

The highest-level economic aim of the US is maximum sustainable GDP growth, with low inflation. In today’s world, the burden of achieving this falls almost entirely on the Fed (even I realize I write this too much, but: the rest of Washington is dysfunctional). The unwritten agreement within government is that the Fed will do things that are economically necessary but not politically popular, accepting associated blame, and the rest of Washington will leave it alone.

Mr. Trump seems, despite his Wharton diploma, not to have gotten the memo. This despite the likelihood that his strange mix of crony-oriented tax cuts and trade protection has made so few negative ripples in financial markets because participants believe the Fed will act as an economic stabilizer.

What happens, though, if the Fed is politicized in the way Mr. Trump appears to want?

The straightforward US example is the 1970s, when the Fed succumbed to Nixonian pressure for a too-easy monetary policy. That resulted in runaway inflation and a plunging currency. By 1978, foreigners were requiring that Treasury bonds be denominated in German marks or Swiss francs rather than dollars before they would purchase. The Fed Funds rate rose 20% in 1981 as the monetary authority struggled to get inflation under control.

The point is the negative effects are very bad and happen surprisingly quickly. This is more problematic for the US than for, say, Japan because about half the Treasuries in public hands are owned by foreigners, for who currency effects are immediately apparent.

The Trump administration has just triggered the latest round of tit-for-tat tariffs with China, declaring 10% duties on $200 billion of imports (the rate to be raised to 25% after the holiday shopping season). China has responded with tariffs on $60 billion of its imports from the US. Domestic firms affected by the Trump tariffs are already announcing price increases intended to pass on to consumers all of the new government levy.

It isn’t necessarily that simple, though. The open question is about market power. Theory–and practical experience–show that if a manufacturer/supplier has all the market power, then it can pass along the entire cost increase. To the degree that the customer has muscles to flex, however, the manufacturer will find it hard to increase prices without a significant loss of sales. If so (and this is the usual case), the company will be forced to absorb some of the tariff cost, lowering profits.

From an analyst’s point of view, the worst case is the one where a company’s customers are especially price-sensitive and where substitutes are readily available–or where postponing a purchase is a realistic option.

Looking at the US stock market in general, as I see it, investors factored into stock prices in a substantial way last year the corporate tax cut that came into effect in January. They seem to me to be discounting this development again (very unusual) as strong, tax reduction-fueled earnings are reported this year. However, the tax cut is going to be “anniversaried” in short order–meaning that reported earnings gains in 2019 are likely going to be far smaller than this year’s. The Fed will also presumably be continuing to raise short-term interest rates. Tariffs will be at least another tap on the brakes, perhaps more than that.

Because of this, I find it hard to imagine big gains for the S&P 500 next year. In fact, I’m imagining the market as kind of flattish. Globally-oriented firms that deal in services rather than goods will be the most insulated from potential harm. There will also be beneficiaries of Washington’s tariff actions, although the overall effect of the levies will doubtless be negative. For suppliers to China or users of imported Chinese components, the key issues will be the extent of Chinese exposure and the market power they wield.

PS Hong Kong-based China stocks have sold off very sharply over the past few months. I’m beginning to make small buys.

One of Mr. Trump’s first actions as president was to withdraw the US from the Trans-Pacific Partnership, a consortium of world nations seeking, among other things, to halt Chinese theft of intellectual property.

…and metals

Trump has apparently since discovered that this is a serious issue but has decided that the US will go it alone in addressing it. His approach of choice is to place tariffs on goods imported from China–steel and aluminum to start with–on the idea that the harm done to China by the tax will bring that country to the negotiating table. In what seems to me to be his signature non-sequitur-ish move, Mr. Trump has also placed tariffs on imports of these metals from Canada and from the EU.

This action has prompted the imposition of retaliatory tariffs on imports from the US.

the effect of tariffs

–the industry being “protected’ by tariffs usually raises prices

–if it has inferior products, which is often the case, it also tends to slow its pace of innovation (think: US pickup trucks, some of which still use engine technology from the 1940s)

–some producers will leave the market, meaning fewer choices for consumers; certainly there will be fewer affordable choices

–overall economic growth slows. The relatively small number of people in the protected industry benefit substantially, but the aggregate harm, spread out among the general population, outweighs this–usually by a lot

is there a plan?

If so, Mr. Trump has been unable/unwilling to explain it in a coherent way. In a political sense, it seems to me that his focus is on rewarding participants in sunset industries who form the most solid part of his support–and gaining new potential voters through trade protection of new areas.

automobiles next?

Mr. Trump has proposed/threatened to place tariffs on automobile imports into the US. This is a much bigger deal than what he has done to date. How so?

–Yearly new car sales in the US exceed $500 billion in value, for one thing. So tariffs that raise car prices stand to have important and widespread (negative) economic effects.

–For another, automobile manufacturing supply chains are complex: many US-brand vehicles are substantially made outside the US; many foreign-brand vehicles are made mostly domestically.

–In addition, US car makers are all multi-nationals, so they face the risk that any politically-created gains domestically would be offset (or more than offset) by penalties in large growth markets like China. Toyota has already announced that it is putting proposed expansion of its US production, intended for export to China, on hold. It will send cars from Japan instead. [Q: Who is the largest exporter of US-made cars to China? A: BMW –illustrating the potential for unintended effects with automotive tariffs.]

More significant for the long term, the world is in a gradual transition toward electric vehicles. They will likely prove to be especially important in China, the world’s largest car market, which has already prioritized electric vehicles as a way of dealing with its serious air pollution problem.

This is an area where the US is now a world leader. Trade retaliation that would slow domestic development of electric vehicles, or which would prevent export of US-made electric cars to China, could be particularly damaging.

This has already happened once to the US auto industry during the heavily protected 1980s. The enhanced profitability that quotas on imported vehicles created back then induced an atmosphere of complacency. The relative market position of the Big Three deteriorated a lot. During that decade alone, GM lost a quarter of its market share, mostly to foreign brands. Just as bad, the Big Three continued to damage their own brand image by offering a parade of high-cost, low-reliability vehicles. GM has been the poster child for this. It controlled almost half the US car market in 1980; its current market share is about a third of that.

In sum, I think Mr. Trump is playing with fire with his tariff policy. I’m not sure whether he understands just how much long-term damage he may inadvertently do.

stock market implications

One of the quirks of the US stock market is that autos and housing are key industries for the economy but neither has significant representation in the S&P 500–or any other general domestic index, for that matter.

Tariffs applied so far will have little direct negative impact on S&P 500 earnings, although eventually consumer spending will slow a bit. So far, fears about the direction in which Mr. Trump may be taking the country–and the failure of Congress to act as a counterweight–have expressed themselves in two ways. They are:

–currency weakness and

–an emphasis on IT sector in the S&P 500. Within IT, the favorites have been those with the greatest international reach, and those that provide services rather than physical products. My guess is that if auto tariffs are put in place, this trend will intensify. Industrial stocks + specific areas of retaliation will, I think, join the areas to be avoided.

Of course, intended or not (I think “not”), this drag on growth would be coming after a supercharging of domestic growth through an unfunded tax cut. This arguably means that the eventual train wreck being orchestrated by Mr. Trump will be too far down the line to be discounted in stock prices right away.

It’s not clear to me whether Mr. Trump’s macroeconomic policy forms a coherent whole (so far it doesn’t seem to). I’m not sure either whether, or how well, he understands the implications of the steps he’s taking.

The major thrusts:

income taxes

Late last year, the Trump administration passed an income tax bill. It had three main parts:

–reduction in the top corporate tax rate from 35% (highest in the world) to 21% (about average). This should have two beneficial effects: it will stop tax inversions, the process of reincorporating in a foreign low-tax country by cash-rich firms; and it removes the rationale for transferring US-owned intellectual property to the same tax-shelter destinations so that royalties will also be lightly taxed.

–large tax cuts for the wealthiest US earners, continuing the tradition of “trickle down” economics (which posits that this advantage will somehow be transmitted to everyone else)

–failure to eliminate special interest tax breaks, or adopting any other means for offsetting revenue lost to the IRS from the first two items.

Because of this last, the tax bill is projected to add $1 trillion + to the national debt over time. Also, since the reductions aren’t offset by additional taxes elsewhere, the tax cuts represent a substantial net stimulus to the US economy.

This might have been very useful in 2009, when the US was in dire need of stimulus. Today, however, with the economy at full employment and expanding at or above its long-term potential, the extra boost to the economy is potentially a bad thing, It ups the chances of overheating. We need only look back to the terrible experience of runaway inflation the late 1979s to see the danger–something which would require a sharp increase in interest rates to curtail.

interest rates

Arguably, the new income tax regime gives the Fed extra confidence to continue to raise interest rates back up to out-of-intensive-care levels. More than that, the tax cut bill seems to me to demand that the Fed continue to raise rates. Oddly–and worryingly, Mr. Trump has begun to jawbone the Fed not to do so. That’s even though the current Fed Funds rate is still about 100 basis points below neutral, and maybe 150 bp below what would be appropriate for an economy as strong as this. Again this raises the specter of the political climate of the 1970s, when over-easy money policy was used for short-term political advantage …and of the 20%+ interest rates needed in the early 1980s to undo fiscal and monetary policy mistakes.

trade

This is a real head-scratcher.

“national security”

The Constitution gives Congress control over trade, not the executive branch of government. One exception–Congress has delegated its power to the president to act in emergency cases where national security is threatened. Mr. Trump argues (speciously, in my view) that there can be no national security if the economy is weak. Therefore, every trade action is a case of national security. In other words, this emergency power gives the president complete control over all trade matters. What’s odd about this state of affairs is that so far Congress hasn’t complained.

There are two main ways in which a country can shield a domestic industry from foreign competition. Tariffs are taxes on imports, which make foreign goods more expensive for domestic purchasers. Quotas are limits on the amount of a foreign good that can be imported over a specific time period. The first controls the price of the foreign good, the second its availability. Unless the quota is set at an wildly high level, tariffs and quotas have generally the same effect.

The main impact is that both allow domestic producers to raise prices. This is very good for those working in the protected industry, which will have higher profits than before. It’s at least mildly bad for everyone else, who will have fewer choices and must pay more for what they need.

infant industries/developing countries

There can be a legitimate place for trade protection. A developing country, for example, may want to establish a textile manufacturing industry. In the early days, the infant industry may not have the technical skill or economies of scale to compete with more established foreign competitors. So the home country government may limit foreign competition for a period of time to give the new endeavor a chance to get on its feet. Tariffs/quotas may also guard against predatory pricing by foreign firms that want to keep the local industry from ever developing into a competitor by “dumping” product at below production cost.

effects of protection

There are several:

–overall GDP growth slows; domestic users of imported goods or their domestic substitutes now pay higher prices and are most likely worse off. This economic loss may be hard to trace back to the protection, making the tactic more attractive to elected officials

–economic energy shifts to the protected industries, which raise prices and become more profitable. In many instances, however, the protected industry doesn’t modernize but simply collects the extra revenue and continues its outmoded/inefficient practices. So it falls progressively further behind world standards, with it and domestic consumers ending up worse off in the long run vs. having had no protection. The domestic auto/light truck industry in the US during the 1980s is a prime example.

–affected parties figure out how to deal with tariffs. In the case of the 25% US tariff on light trucks imported into the US, protection forced foreign automakers to establish plants in the US to serve the market. In the case of current US tariffs on imported aluminum and steel, on the other hand, manufacturers who use these inputs have cancelled US expansion plans and have begun to shift production to other countries.

–we can see the negative long-term effects of protectionism around the world in the ossified telecom industry in the EU, the pickup truck business in the US, the semi-bankrupt state-owned industries in China or the senescent keiretsu structure in Japan. Generally speaking, except for infant industries in developing countries, the state planning that tariffs exemplify seems to have worked out pretty badly just about everywhere in the OECD.

retaliation

When a country alters the trade status quo by applying a tariff or import quotas, the affected countries most often respond in a tit-for-tat fashion. The original tariff is intended to help a politically important industry in the home country. The response, called retaliation, has the aim of hurting a politically important industry in the home country. If it also helps an industry in the original target, fine; if not, also fine. In this sense, retaliation is different from the initial tariff.

After the US placed tariffs on imported steel and aluminum, for example, the EU has responded with a retaliatory tariff on imports of Harley Davidson motorcycles (an early supporter of Mr. Trump) made in the US. China has placed a similar retaliatory tariff on US soybeans. HOG has since announced plans to move manufacturing of Harleys for export to the EU from the US to Thailand. Chinese soybean buyers have shifted to Brazilian output, a loss that US farmers worry may end up being permanent.

Next time: the Trump tariff plans, as far as I can figure out, and stock market implications

I’m taking off my hat as an American and putting on my hat as an investor for this post.

That is, I’m putting aside questions like whether the Trump agenda forms a coherent whole, whether Mr. Trump understands much/any of what he’s doing, whether Trump is implementing policies whispered in his ear by backers in the shadows–and why congressmen of both parties have been little more than rubber stamps for his proposals.

My main concern is the effect of his economic policies on stocks.

the tax cut

The top corporate tax rate was reduced from 35% to 21% late last year. In addition, the wealthiest individuals received tax breaks, a continuation of the “trickle down” economics that has been the mainstay of Washington tax policy since the 1980s.

The new 21% rate is about average for the rest of the world. This suggests that US corporations will no longer see much advantage in reincorporating abroad in low-tax jurisdictions. The evidence so far is that they are also dismantling the elaborate tax avoidance schemes they have created by holding their intellectual property, and recognizing most of their profits, in foreign low-tax jurisdictions. (An aside: this should have a positive effect on the trade deficit since we are now recognizing the value of American IP as part of the cost of goods made by American companies overseas (think: smartphones.)

My view is that this development was fully discounted in share prices last year.

The original idea was that tax reform would also encompass tax simplification–the elimination of at least part of the rats nest of special interest tax breaks that plagues the federal tax code. It’s conceivable that Mr. Trump could have used his enormous power over the majority Republican Party to achieve this laudable goal. But he seems to have made no effort to do so.

Two important consequences of this last:

–the tax cut is a beg reduction in government income, meaning that it is a strong stimulus to economic activity. That would have been extremely useful, say, nine years ago, but at full employment and above-trend growth, it puts the US at risk of overheating.

–who pays for this? The bill’s proponents claim that the tax cut will pay for itself through higher growth. The more likely outcome as things stand now, I think, is that Millennials will inherit a country with a least a trillion dollars more in sovereign debt than would otherwise be the case.

One positive consequence of the untimely fiscal stimulus is that it makes room for the Fed to remove its monetary stimulus (it now has rates at least 100 basis points lower than they should be) faster, and with greater confidence that will do no harm.

Two complications: Mr. Trump has begun to jawbone the Fed not to do this, apparently thinking a supercharged, unstable economy will be to his advantage. Also, higher rates raise the cost of borrowing to fund a higher government budget deficit + burgeoning government debt.

Modern economics has been founded in study of what caused the Great Depression of the 1930s, with an eye to preventing a recurrence of this devastating period. We know very clearly that tariffs and quotas are, generally speaking, bad things. They reduce overall economic activity in the countries that apply them. Yes, politically favored industries do often get a benefit, but the cost to everybody else is many times larger. We also know that the use of tariffs and quotas can snowball into a storm of retaliation and counter-retaliation that can do widespread damage for a long time.

My point is that it’s inconceivable that high-ranking public officials in Washington don’t know this.

HOG motorcycles are Baby Boomer counterculture icon. The company’s traditional domestic male customer base is aging, however, and losing the strength and sense of balance required to operate these heavy machines. At the same time, HOG has had difficulty in attracting younger customers, or women or minority groups to its offerings. So it’s an economically more fragile firm, I think, than the consensus realizes.

HOG has been damaged to some degree by the Trump tariffs on aluminum and steel, which are important raw materials. (As I understand them, the tariffs are ostensibly to address Chinese theft of US intellectual property, although they are being levied principally against Japan and the EU. ???)

Completely predictably, the EU is retaliating against the tariffs. In particular, it is levying its own 25% tariff on HOG motorcycles imported from the US. This affects about 20% of Harley’s output. HOG says the levy will cost it $100 million a year in lost income, implying that all of the EU-bound Harleys are now made in the US. HOGs response is to shift production targeted for the EU to its overseas plants. My guess is that this will take 1000+ jobs out of the US.

In contrast to the job loss from this one company, public reports indicate the total job gain from the steel/aluminum tariffs to be about 800 workers being recalled to previously idle steel/aluminum plants.

Mr. Trump’s response to the HOG announcement was to threaten punitive tariffs on any imports of foreign-made Harleys–a move that could threaten the viability of HOG’s network of around 700 independent dealerships. 7000 jobs at risk?

The stock market declined sharply on the day of the HOG announcement. I think that’s because the HOG story is a shorthand illustration of how tariffs, and quotas, cause net losses to the country as a whole, although they may bring benefits to a politically favored few.

A second negative effect of trade protection is a long-term one. My experience is that most often the protected industry, relieved of immediate competitive pressure, ceases to evolve. After a few years, consumers become willing to pay the increased price to get a (better) imported product. In my mind, General Motors is the poster child for this.

Stock market implications? …avoid Industrials. The obvious beneficiary of Washington’s ill-thought out trade policy is IT. For the moment, however, I think that this group is expensive enough that Consumer Discretionary and Energy are better areas to pick through.